Sunday, February 06, 2005
House prices may wobble but won't crash to earth
Posted by David Smith at 11:01 AM
Category: David Smith's other articles

On this Sunday morning, with the spring daffodils pushing through the cold February soil, talk of a housing crash may seem gloomy. But that is what I want to talk about.

Not that such talk is new. The first housing-crash story I could find in the present cycle came in 1996, when one Bob Beckman predicted a 20-year fall in prices. There was another batch in 1997, when the fear was that Labour’s election would hit house prices hard.

In 1998 and 1999, when the stock market was booming, there was a steady trickle of housing-crash predictions, building further when the stock-market boom turned to bust in 2000. The September 11 attacks on America persuaded many that housing was about to take a dive and, in the three years since, talk of a housing crash has built up to a crescendo.

So why revisit it? On Thursday, at the RAC Club, I debated the issue with Roger Bootle, head of Capital Economics. The event, kindly sponsored by Sector Treasury Services, was the unexpurgated version of a briefer run-in we had before Christmas. So how did it go?

As I put it, from the “soft landing” perspective, there are three key questions. The first is whether a house-price crash can happen without an overall recession in the economy. Every previous “crash” in house prices, in the depression of the early 1930s, in the turbulent 1970s (1973-76), in the late 1970s and early 1980s, and most recently in the early 1990s, was accompanied by a severe recession. The crash of the early 1990s followed a doubling of interest rates, from 7.5% to 15%, and a near-doubling of unemployment, from 1.6m to 3m.

Bootle’s argument was that house prices then started to fall ahead of the rise in unemployment. Both housing and the job market were subject to the same negative influence, a sharp interest-rate rise.

Except that the housing crash of the early 1990s did not really get going until unemployment was rising sharply and small firms were failing in their tens of thousands. By mid-1990, prices were just 1.6% lower than a year earlier. Over the following 12 months, prices slipped by a mere 0.2%. The worst year for the market was 1992, in the autumn of which prices were recording a 12-month fall of 8.7%.

This came after the big rise in unemployment and when the government lost control of economic policy (subsequently grabbing it back) with sterling’s expulsion from the ERM. So the claim stands. Can house prices crash without a general recession? I think not. Is there going to be such a recession? After 50 successive quarters of growth there is no sign of it.

The second argument related to actual, rather than “real” or inflation-adjusted, house prices. There were only two occasions in the 20th century when actual prices fell substantially — during the depression of the early 1930s and in the early 1990s. On both occasions, curiously, the peak-to-trough fall in prices was 13%.

Mostly, as in 1973-76, 1979-82 and partly in the early 1990s, a much bigger real fall occurred because prices stagnated while more general inflation — 27% in 1975, 22% in 1980, 11% in 1990 — ran its course.

Bootle’s argument is that, with inflation low, actual and real will become more or less the same thing. Without inflation to disguise things, actual prices will have to fall, by 20% in his view, to correct the market’s overvaluation.

Except, to me, that is not how the housing market works. Sellers will not cut prices unless forced to do so by economic circumstances. Most house moves are voluntary; people have a choice whether to go ahead or not. If the choice is between selling at a price they consider too low, most will withdraw the property from the market. House prices, in a phrase invented by Lord Keynes, are “sticky downwards”. This is a recipe for stagnation, not a crash.

My third argument was about the house price/earnings ratio, the traditional measure used to assess whether the market is overvalued. Depending on which version you use, the ratio is currently about 5.5, or even higher, against a long-run average of under 4. Bootle said this showed the need for a drop in prices.

My take was rather different. Leaving aside the question of whether the notion of average earnings belongs to the age of mainly industrial employment and has much meaning these days, two things have happened to the housing market in recent years which justify a permanent revaluation. The first was the liberalisation of the mortgage market to new entrants in 1982, and which may only have come fully on stream with the intense competition of the 1990s and beyond. Before 1982 mortgages were rationed, building societies and local authorities the only providers.

The other effect has been the permanent change in interest rates. In 1979-97 the base rate averaged 10.4%; in the period since, it has averaged 5.3%. This change justifies a big shift in the house price/earnings ratio. Bootle argued correctly that real (after-inflation) interest rates have not come down as much as actual rates, and that homebuyers no longer get mortgage relief. But actual interest rates — and actual monthly mortgage payments — are the main determinant of what people will pay for houses and how much they will borrow. The change here has been huge and, as I say, looks permanent.

To be fair to Bootle, there were other arguments. In real terms, he argued, the recent house-price boom has been more powerful than its predecessors — prices rising strongly at a time of low inflation. House prices, he noted, have risen more sharply than other assets, most notably equities and commercial property.

The interest-rate burden on homebuyers may be low, he said, but when debt repayment is taken into account, it is set to increase strongly. First-time buyers are being kept out of the market across the country by high prices, and the difficulty of scraping together a deposit.

All good points. But none seemed to me, or to an audience that voted 2:1 for a soft landing, to be clinchers. The latest evidence from Nationwide and Halifax suggests prices rose last month. Mortgage approvals appear to have stabilised. If it looks like a soft landing, which it does, it probably is.

PS: What is the effect on interest rates of too much government borrowing? That should be easy. If Gordon Brown fails to control his budget deficits — injecting money into the economy — rates will be higher than would otherwise be the case. Mervyn King, the Bank of England governor, warned as much last month.

But what happens if people expect higher budget deficits to result in higher taxes, even if not until after the election? According to Patrick Minford of the Cardiff Business School, the case then is for interest rates to be cut, not raised.

Minford was taking part in the latest discussion of the “shadow” monetary policy committee, which operates under the auspices of the Institute of Economic Affairs. He thinks economic prospects are weak enough to justify an immediate cut. The other eight members disagree.

The majority that voted for no change look to have it about right. If the real MPC votes to leave the base rate at 4.75% on Thursday, as is expected, that will mark the sixth month without a change, and the second inflation report month (they come in February, May, August and November) in which the Bank has opted for the status quo. The longest period of unchanged rates in its period of independence came between November 2001 and February 2003, when there was no change for 14 months. We may be heading that way again.

From The Sunday Times, February 6 2005


Oh dear, this is a sensitive subject.

If we assemble the evidence, there’s Rightmove’s January House Price Index report:

The report shows house prices have been flat since last July (page 14). But there are less houses coming onto the market, some have been withdrawn and the rest are taking longer to sell (pages 3 & 4).

There’s mortgage lending data and Mortgage Equity Withdrawal (to Q3 2004) data from the BoE. I’ve posted the graphs here:

Mortgage approvals dropped dramatically last year, from 133,000 in Dec. 2003 to 83,000 in Dec. 2004. Things were fine until July but then approvals started to fall rapidly.

What happened in July? Well, interest rate rise numbers three to five occurred in May, June and August last year. I think we need look no further.

How to interpret steady prices but low sales? It looks as though the houses still selling at peak prices are the exceptional, top quality ones or ones where people are just moving from one house to a similar one.

What has ended is the ability to sell an ordinary house at a high price. Whereas people were previously prepared to buy an ordinary house in the expectation of a capital gain, higher interest rates have now washed the scales from their eyes.

Of course this still doesn’t mean house prices will fall. But it’s a Catch 22 situation. If the old 133,000 people per month now try to sell at a high price, they’re crazy. But if they don’t try to sell at all, their houses must still have a high price.

Mervyn King and his team are going to have to play a blinder on this one or we’re all relegated.

Unfortunately I think they’ll have no choice but to raise rates again – and this Thursday would be the best time.

Posted by: David Sandiford at February 7, 2005 03:13 AM

The increase in property tax also needs to be factored in – and extra 1-10,000 in property tax is effectively an extra 1-2% on top of interest rates – so interest rates will have gone up by more than you think.

The mortgage equity withdrawl graphs interesting – what drives it? Retirement – emigration – my graph of old age emigration tracks it quite closely.

Posted by: Giles at February 8, 2005 01:05 AM

That’s right, the costs of owning a bigger property are rising – utility bills as well as local tax. Higher costs make it difficult to pay the mortgage. But people were willing to take on a big mortgage if they were sure of a capital gain in the long run. However they’re not so sure now and the drop in mortgage approvals shows just how speculative the market had become.

But if that’s bad, Mortgage Equity Withdrawal is a ticking bomb. Certainly some money must have been taken abroad – retirees taking advantage of the cycle. But most of the cash (extracted by taking on a bigger mortgage with a house move, or just increasing the mortgage) has been blown on a huge spending binge – hence the UK trade deficit.

That spending created jobs, increased property prices and encouraged more MEW – to the tune of £55bn in 2003.

But if MEW spending dries up and Gordon Brown throws in £10bn of extra taxes…

The UK in a uniquely vulnerable position, hence the call for a rate cut. Unfortunately, I don’t think Mervyn is in a position to oblige.

Posted by: David Sandiford at February 8, 2005 06:19 AM

If the last three rate rises have knocked the speculative element out of the property market for now then Mervyn can be well pleased. It fits with his Zen-like stance that a house is just a house.

But the view that you can’t go wrong with property and houses always appreciate in the long run still isn’t dead. Therefore if inflation, interest rates and employment remain unchanged property speculation is likely to return.

But interest rates are going to have to increase – for two reasons. Inflation is on the rise and the current base rate is still stimulative, not neutral.

I’ve posted graphs of inflation and interest rates here:

Looking at the old target inflation measure - RPIX, inflation has risen from 1.88% in Sept. 2004 to 2.53% in Dec. 2004.

Now the headline RPIX figure is an annual rate – the accumulation of the previous twelve months. But individual monthly RPIX inflation was above the long-term average from Oct. to Dec. 2004. So inflation is genuinely rising.

Going forward, even if the coming six months have inflation at the long-term average level, the headline RPIX figure will still rise to 2.9% in April and 3.0% in June. The old target was 2.5%.

Now, is the current base rate stimulative? Subtracting RPIX inflation from the Base Rate (see graph) gives an idea of the ‘real’ interest rate. (OK, it’s not perfect but let’s give it a go).

The graph shows the ‘real’ rate was mostly 3% to 4% for the ‘normal’ inter-recession period of 1994 to 2000. The ‘real’ rate reached 2.87% last Sept. but fell back to 2.22% in Dec. - because inflation had increased when the base rate had not.

So the MPC’s current rate is still not ‘normal’ and will become more stimulative as inflation rises. They must raise rates at some point, preferably soon.

As a separate issue, consider US interest rates. Subtracting Core CPI inflation from the Fed Funds rate gives an idea of ‘real’ US interest rates. (This isn’t perfect either).

Again, the ‘real’ rate is still stimulative because of the recent rise in inflation. The Fed is trying to return real rates to normal. That means at least another 2% increase – probably this year. The US rise will put pressure on the MPC to raise rates.

Interestingly, the situation is just like 1994 (see US graph). 1994 is famous for two things – the bond price crash and the Mexican peso crisis. Mexico was considered a miracle economy at the time and was receiving lots of foreign investment. However Mexico had borrowed far too much money and a sudden difficulty in making repayments caused an escalating crisis.

Mexico and the other emerging economies are in good shape today. So which country is erroneously held in high regard, has high debts and is vulnerable to interest rate rises? Oh, oh. If you can’t spot the Mexican at the table then it’s you. Ay Caramba!

As a final clincher, surely any country that boasts a nail-decorating salon on every high street has definitely lost the plot. Banana, anyone?

Posted by: David Sandiford at February 8, 2005 06:30 AM

"Mexico was considered a miracle economy at the time"

Mexico was never considered a miracle economy at the time - I'd had a dire 80's and then acheived a couple of decent years before the crisis. Didnt exactly have a reserve currency either.

The other point of interest is the government in particular Mr TB; he's got a mortgage that costs him about 75k pa on a property with no tenants. Wife's taken early retirement but is backpacking downunder to raise the readies. The interesting question is whether TB can resign and get a day job before the market turns. Otherwise it could get quite embarrasing.

Posted by: giles at February 9, 2005 03:03 AM

El Tone must be spitting feathers. First there was Cheriegate and all the embarrassing revelations about Carole Caplin and Peter Foster – the Blairs still have the flats in Bristol too.

Then there was the ‘flowers’ story:,12713,1406555,00.html

Now, just when the fuss was dying down, Cherie hooks up with some dodgy PR bloke in Australia, a Max Markson of Markson Sparks (oh, I bet he regrets that name now), and to top it all she insults the New Zealand PM and the entire nation by calling them Aussies. There won’t be many book sales there.

Speaking of exports, the UK trade figures were released today:

“For the year as a whole, UK’s deficit on goods and services rose to a record £39.3 billion. A record surplus on trade in services of £18.3 billion partly offset a record deficit of £57.6 billion on trade in goods. Excluding oil and erratic items, the volume of exports were up by two per cent while imports rose by five and a half per cent to reach a record annual level.”

The MPC’s problem is that, if consumer spending does fall, will Brits stop buying UK goods or imports - like BMWs and long-haul holidays? Yes, that’s my guess too.

Meanwhile, El Tone might just be wishing he’d gone for a retired life of well-paid lecture tours in the US rather than face ‘four more years’.

Posted by: David Sandiford at February 9, 2005 11:42 AM

"if consumer spending does fall"

The pounds likely to fall as well - meaning that demand for say long haul holidays will go down as well.

I'm not worried about the UK external balance postions - gross external debts and assets are about 300% of GDP and this provides a sort of automatic stabaliser - as the pound goes down, the increased relative value of externally denominated foreign assets goes up helping to balance the capital account.

Posted by: giles at February 9, 2005 09:00 PM

“The pound’s likely to fall as well”

If the pound is likely to fall, inflation is likely to rise and the MPC will have to raise interest rates – which leads us neatly into today’s decision.

I’m not so sure about the automatic stabiliser. This is Greenspan’s argument, that price is everything – if imported luxuries rise in price then people will buy less of them.

In the US people might just borrow more to buy European goods. But in the UK, if MEW dries up, what will people do?

This is another area where the UK is uniquely vulnerable. The dog that hasn’t barked yet is wage inflation. If we have full employment, why aren’t wages shooting up? My theory is that, given weak union power, workers have chosen the path of least resistance and borrowed more rather than demand more wages.

But if they can’t borrow more, will they give up the imported luxuries they’ve become used to? Other conditions remaining unchanged, they will demand more wages. And wage inflation will cause the MPC to raise rates.

I think the MPC should raise interest rates today (a) to tackle rising inflation, (b) to blow the final whistle on property speculation and (c) because recent retail, manufacturing and trade data show it’s safe to do so.

The MPC likes to change rates when they have a new Quarterly Inflation Report followed by a Press Conference, as this month. If they wait, anything they do or say in April or May will be swamped by the election and there will be nothing new in March.

Will a rise of 0.25% today cause house prices to fall? Well, hardly – but three or four this year should start to bite.

Interestingly, the three witches met upon the blasted heath this week – well, Brown, Greenspan and King met in Edinburgh. They must all know the answers to the two questions we’d all like to have answered: Where will interest rates be in a few months time and where will Gordon Brown be in a few months time?

I think UK interest rates still have to rise by at least 1% and the house price bubble will deflate. A fall in nominal house prices of 20% over three years plus 10% for RPIX inflation gives a real drop of 30% over the next three years.

Yes there will be media hysteria but will there be a recession? There could be a negative spiral of less MEW, less spending, less employment, less company profits, lower sterling, rising inflation, rising interest rates, falling house prices, etc.

It’s a tough problem for the MPC. It depends as much on game theory as economics. I hope Merv is wearing his magic boots.

Posted by: David Sandiford at February 10, 2005 06:28 AM

"The Bank of England's Monetary Policy Committee today voted to maintain the Bank's repo rate at 4.75%."

Oh well, pass the tequila.

Posted by: David Sandiford at February 10, 2005 12:52 PM

This is getting a bit too gloomy. Work done by Sushil Wadhwani when he was a member of the MPC suggested that the pass-through from a lower exchange rate to inflation is likely to be much lower than in the past. Meanwhile, sterling does not look like a bad bet compared with the sclerotic euro zone and a dollar that looks to me to have further to fall, notwithstanding Alan Greenspan.

Posted by: David Smith at February 10, 2005 08:05 PM

"This is getting a bit too gloomy."

Nothings too gloomy for Death Rider David!

Before we even get to the path through question, I think it’s hard to foresee a scenario where the pound devalues substantially against the Euro - which accounts for about half of imports. And I cant see that happening unless the Euro are experiences a sudden growth miracle, the UK collapses and a significant ECB –UK interest rate difference opens up. The chance of a combination of all three are, I think, small

Posted by: giles at February 11, 2005 03:25 AM

I’m sorry; it’s only my dark sense of humour.

My argument was based on RPIX inflation rising. But the new measure is CPI inflation and that’s still well below the 2% target – which must please Gordon Brown. So, superficially, there’s no need to worry.

But I think CPI is a rotten target because it doesn’t take proper account of the housing market.

I also think inflation targeting has turned out to be an example of Goodhart’s Law (when you target something, behaviour changes to make the target useless). That’s because inflation targeting has done nothing to prevent asset price bubbles.

And the idea that monetary policy is all you need to control everything from trade to employment to housing is ridiculous. Obviously fiscal policy is important.

But why doesn’t Gordon Brown face a webcast press conference every three months to explain himself?

The housing market is far too important to be left to property speculators but Gordon Brown has done nothing.

The, so-called, ‘holiday cottage’ boom that has emptied villages exists because of expected capital gains. Why hasn’t Gordon Brown taxed away some of the unrealised capital gain or taxed loans for holiday cottages?

The same goes for buy-to-let, or ‘borrow to capital gain’. The boom has priced first time buyers out of the market but Gordon Brown has not taxed the loans or the speculative gains, directly or indirectly.

The government is offering to help first time buyers – financially. But they haven’t built houses for them. This is ludicrous. It just tempts more punters into the Ponzi Scheme that is the UK property market.

We can’t blame the MPC for this situation but they will have to cope if it goes wrong. Of course, you’re both right, a run on sterling is very, very unlikely. But it would only be a symptom, not the disease. If the MPC finds itself forced into raising rates when unemployment is rising for some reason, it won’t be much fun.

We know the meeting’s result. I wish we didn’t have to wait until Feb. 23rd for the final score of who voted for what.

But I hope you’ll give them a good grilling at the Press Conference, David. I’ll be watching the webcast on the edge of my seat.

Posted by: David Sandiford at February 11, 2005 05:11 AM

There’s a contradiction in the argument though – if a real inflation measure should include house prices and we’re agreed that house prices are now flat – while you’re arguing they’re falling, then surely its deflations that’s the greater risk?

I’m not discounting the possibility that inflation may become a problem but given that the UK has been running a tight monetary compared to the rest of the world, I think any threat of inflation is likely to be external – i.e. arising through global inflation caused by the Feds loose monetary policy and the Chinese plan to inflate their way out of trouble.

Posted by: giles at February 11, 2005 03:45 PM

What we’d like is an inflation measure that’s really meaningful about the cost of living for most people – and therefore includes the cost of acquiring a house.

The old RPIX measure that included a house-price-related component says inflation has been bang on target at 2.5% for the last twelve months.

The new CPI measure that doesn’t have that component says inflation has only been 1.6% for the last twelve months, compared to the 2% target.

I haven’t looked any further but I assume the difference has much to do with the fact that house prices have still risen by 10% over the last twelve months – although they’ve been flat for the last six months.

So if house prices do fall by, say, 5% over the next twelve months then there will be less direct inflation and less indirect inflation (from consumer spending and wage pressure to support high mortgages). Therefore the MPC could hold back on rate rises.

But is that why they held back this time – because they expect a house price fall? If so, all they’ve done is to encourage speculators back into the market.

If I were at the press conference I’d ask them if they think current rates are stimulative or neutral. If stimulative, why is the stimulus still necessary and if neutral, why aren’t they worried about the signs of inflation (internal and external)?

Do you have a question for Mervyn King, Giles?

Posted by: David Sandiford at February 12, 2005 09:20 AM

Right now I think that inflation is irrelevant. Sure, the CPI isn’t a perfect measure because it under weighs house prices – but you’ll also find some who say it overstates inflation because it under weighs ITC goods. At the end of the day the CPI is just a rough measure of aggregate price level and if it occasionally under weights prices in one markets like housing, then there’s a sort of automatic stabilizer built in. If house prices have risen above the rate of inflation in the upswing of this cycle, they’re likely to fall below the rate of inflation in the down swing. Over the cycle the CPI should therefore be just about right. So while I agree that at the moment it may therefore be understating inflation by not including house prices, this is very much a known known as we’ve been here a hundred times before.

Where we haven’t been is in a situation where the MPC has to make a tough choice between its inflation target and some other domestic target, particularly if it was under pressure from the government. My death ride is the deficit which I think is far more serious than is being let on. As the early 90’s showed, the fiscal position in the UK can change with alarming rapidity and given that, with good growth, we’re already starting from a negative 3-4% position, a fall in growth to say -1% – 1% over the next couple of years could see the figure pushed towards the 8% range. Which would be scary. I haven’t seen this government take a tough stand when it could shift the responsibility to some other body. In the event of a rescission, the somebody would be the old lady. So my question to Merv would be “Can you precomitt to say under what range of changes in other macroeconomic variables, growth, unemployment or the debt level would you consider relaxing the inflation target” and “Do you feel that the institutional structures governing the appointment of the MPC and its independence would be robust against a concerted, but not necessarily direct, attack from a “desperate” government?

Posted by: giles at February 12, 2005 09:26 PM

Now in July 2005 with interest rates expectations lower than six months previous there is some evidence that house prices have fallen not just in terms of asking prices but in terms of discounts negotiated against them -in London est 5%. The Lenders ( see Nationwide & Hometrack recent survey ) appear to be expecting some downward correction in sellers expectations as buyers are "holding off". If interest rates do fall what do you (DSmith) think will now happen??? As a potential buyer who sold 12 months ago and have held cash I see house prices as very bad value and feel some downward correction , though small, will yet take place - its a brave man that buys now and pays the asking price .....but equally a brave man that holds out for a better deal with a market that is so difficult to read and predict. I just dont see the demand from BTL and speculative purchases there even with lower rates because capital appreciation just feel a bad bet today ....and with first time buyers really struggling that has to have an effect somewhere. I also see FMCG selling at discounts to move volume which indicates consumers are generally less able to spend and I cant believe that this is just down to interest rates - debt at any price has to be paid off and this must eventually take a toll on demand - a penny for your thoughts ?

Posted by: Rob at July 5, 2005 01:35 AM

My thoughts on this haven't changed much - the period of stagnation in house prices evident since last summer will continue; a stand-off between buyers and sellers. So not much prospect of capital gain.

Posted by: David Smith at July 6, 2005 07:54 PM

A few further months down the line and: "Bootle’s argument was that house prices then started to fall ahead of the rise in unemployment" seems to be valid. The forecasted GDP growth rates for this year seems to be falling at pace. Unemployment has been rising for some months. We may be heading for recession. The chance of Interest rate cuts seem to be receeding as globally inflation has reappeared and central banks worldwide seem intent of raising interest rates, making it extremely hard for the BOE to lower them.

Posted by: Alex A at October 25, 2005 01:49 PM